Output and the Exchange
Rate in the Short Run
Objectives

Causes of output, exchange rates, and inflation changes

Determination of output and exchange rates in the short run

Examine how macroeconomic policy affects output and the current
account and how they can be used to maintain full employment
Determinants of Aggregate Demand in an
Open Economy

An economy’s output is the sum of four types of expenditure that
generate national income: consumption, investment, government
purchases, and the current account

A country’s overall short-run output level depends on the aggregate
demand for its products

In the long run, domestic output depends only on the available
domestic supplies of factors of production

In the short run factors of production can be over or under employed
because of shifts in aggregate demand that have not yet had their full
long-run effects on prices

Aggregate demand for an open economy’s output is the sum of
consumption demand, investment demand, government demand, and
net export demand

For now we assume government and investment demand are given
Determinants of Consumption Demand

Consumption is dependent on disposable income (C = Y – t)

So we take consumption as a function of disposable income
C = C(Yd)
Determinants of Current Account

The current account is dependent on
•
The domestic currency’s real exchange rate against foreign
currency (that is, the price of a typical foreign expenditure basket
in terms of domestic expenditure baskets)
•
Domestic disposable income

A country’s current account balance is a function of its currency’s real
exchange rate, q = EP*/P (price of foreign basket in terms of domestic
basket), and of domestic disposable income, Yd

CA = CA (Ehf x Pf/Ph, Yd)
Determinants of Current Account

Representative domestic expenditure basket places heavier weight on
local goods

Consequently a rise in the price of the foreign basket in terms of
domestic baskets, will cause a rise in the relative price of foreign
output to domestic output

How does this affect exports and imports?

When q rises, foreign products prices rise, domestic output now
purchases fewer units of foreign output

Foreign consumers demand more of your exports raising exports and
improving current account balance
Determinants of Current Account

An increase in Yd causes domestic consumers to increase their
spending on all goods, including imports worsening the current
account
To Summarize
q
= Current Account
q
= Current Account
Yd
= Current Account
Yd
= Current Account
The Equation of Aggregate Demand

AD = C + I + G + (X-M)

AD = C(Y-T) + I + G + CA(EhfPf/Ph, Y-T)

Where Yd = Y-T

Aggregate demand for home output can be written as a function of
the real exchange rate, disposable income, investment demand, and
government spending
AD = D(EhfPf/Ph, Y-T, I, G)

We now want to see how aggregate demand depends on the real
exchange rate and domestic GNP given the level of taxes, T,
investment demand, I, and government purchases, G
The Equation of Aggregate Demand

A real depreciation of the home currency raises aggregate demand for
home output, other things equal; a real appreciation lowers aggregate
demand for home output

a rise in domestic real income raises aggregate demand for home
output, other things equal, and a fall in domestic real income lowers
aggregate demand for home output.
Increase in AD is less than increase
in output, so the slope is less than 1
How Output is Determined in the Short Run

Output market is in equilibrium when real domestic output, equals
aggregate demand for domestic the output:
Y = D(EhfPf/Ph, Y-T, I, G)

We assume money prices of goods and services are temporarily fixed
hence short run implication
How Output is Determined in the Short Run
Y1: demand = output
Y2: demand > output
Y3: demand < output
Output Market Equilibrium in the
Short Run

Determination of exchange rate and output simultaneously in the
short run

Asset market and output market equilibrium
Output, the Exchange Rate and Output
Market Equilibrium
Currency depreciation
raises AD & output by
increasing demand for
local goods/services
DD Schedule
We now derive the DD schedule
- shows all combinations of
output and the exchange rate
for which output market is in
short-run equilibrium (aggregate
demand = aggregate output).
Relates E & Y when P & P* are
fixed
DD Schedule

A change in the following causes a shift in the DD schedule:
•
government demand/purchases,
•
taxes,
•
Investment,
•
Prices (domestic and foreign),
•
Domestic consumption behavior;
•
Foreign demand for home output.
Shift in DD Schedule
Rise in government purchases = rightward
Rise in taxes = leftward
Rise in investment= rightward
Rice in domestic prices = leftward
Rise in foreign prices = rightward
Rise in domestic consumption = rightward
Rise in home output= rightward
Asset Market Equilibrium in the Short
Run – AA Schedule

To have a complete picture we have to ensure that the exchange rate
and output level consistent with output market equilibrium should
also be consistent with asset market equilibrium.

Exchange rate and output combinations that are consistent with
equilibrium in the domestic money market and the foreign exchange
market is called the AA schedule
Output, the Exchange Rate and Asset
Market Equilibrium

Remember interest parity condition (foreign exchange market is in
equilibrium only when the expected rates of return on domestic and
foreign currency deposits are equal)

Remember interest rates that enter the interest parity relationship
are determined by the equality of real money supply and real money
demand in national money markets

Now we combine these asset market equilibrium conditions to see
how the exchange rate and output must be related when all asset
markets simultaneously clear

Foreign interest rate is taken as given
AA Schedule

For a given expected future exchange rate, Ee , the interest parity
condition describing foreign exchange market equilibrium
Rh = Rf + (Ee – E) / E

Domestic interest rate satisfying the interest parity condition must
also equate the real domestic money supply to real money demand
Ms/P = L(R,Y)

Now we can study the changes in the exchange rate that must
accompany output changes so that asset markets remain in
equilibrium

We assume domestic price level, P; foreign interest rate, Rf; and
expected future exchange rate, Ee are given
AA Schedule
A rise in output from Y1 to Y2 raises
aggregate real money demand raises
the equilibrium domestic interest
rate, with Ee and Rf fixed, the
domestic currency appreciates to
bring forex market back into
equilibrium
AA Schedule
For any output level Y, there is a unique
exchange rate E satisfying the interest parity
condition (given the real money supply, the
foreign interest rate, and the expected future
exchange rate)
A rise in output causes a rise in the home
interest rate and a domestic currency
appreciation
Shift in AA Schedule

A change in the following factors causes a shift in the AA Schedule:
•
Domestic money supply, Ms; increase in Ms given fixed output =
domestic currency depreciation in forex market = AA shifts upward
•
Domestic price level, P; increase in P given fixed output = reduction
in Ms = increase in interest rate = domestic currency appreciation in
forex market = AA shifts downwards
•
Expected future exchange rate, Ee; increase in Ee increases r,
shifting r on foreign currency deposits to the right = domestic
currency depreciation = AA shifts upwards
•
Foreign interest rate, R*; increase in R* raises return on foreign
deposits (shifts right) = domestic currency depreciation = AA shifts
upwards
•
Aggregate real money demand; reduction in Md = lower interest rate
= causes a depreciation = shifts AA upwards
DD Schedule & AA Schedule

We find the economy’s short-run equilibrium by finding the
intersection of the DD and AA schedules

The assumption that output is temporarily fixed makes this short run
equilibrium

Further, we continue to assume foreign interest rate Rf, the foreign
price level Pf, and the expected future exchange rate Ee also are
fixed
DD Schedule & AA Schedule:
Short Run Equilibrium
At 2, E jumps from
2 to 3 because
asset
markets
adjust quickly. Y
rises to meet AD &
the
economy
moves to 1
Temporary Changes in Monetary & Fiscal
Policy

Monetary policy (changes in money supply)

Fiscal policy (changes in government spending)

Macroeconomic policies counteract economic disturbances that cause
fluctuations in output, employment, and inflation

We now want to see how shifts in government macroeconomic policies
affect output and the exchange rate.

We assume foreign interest rate, Rf, foreign price level, Pf, domestic
price level, Ph, are fixed in the short run

We assume temporary policy change do not affect the long-run
expected exchange rate, Ee (as in the long run)
Monetary Policy

Increase in Ms pushes down Rh
shifting AA upward but does not
affect DD (1-2)

To
preserve
interest
parity
condition
exchange
rate
depreciates making home products
cheaper than foreign products

AD then increases matched by
increase in output

Increase in Ms causes depreciation
of domestic currency, expansion of
output, and therefore increase in
employment
Fiscal Policy

Increased government
purchases/decreased
taxes raises transaction
increasing
money
demand pushing Rh up

Currency
appreciates
and output increases
Policies to Maintain Full Employment

Temporary monetary expansion and temporary fiscal expansion both
raise output and employment

They can be used to counteract the effects of temporary disturbances
that lead to recessions and the vice versa for booms

What happens if there’s a shift in consumer tastes away from local
products?
A decrease in AD for domestic goods
causes DD to shift leftward, currency
depreciates
and
output
reduces
(indications of recession)
Temporary fiscal expansion shifts demand
back to its original position, restoring full
employment and returning to E1
Temporary monetary expansion shifts the
asset market equilibrium curve right,
restores full employment but cause
further depreciation
Policies to Maintain Full Employment

What happens if there is a temporary increase in demand for money
(likely to cause a recession)?

Increase in money demand pushes up the domestic interest rate and
appreciates the currency, making domestic goods more expensive
and causing output to reduce (shifting AA downward)

Temporary money supply
increase shifts the AA
curve back to AA1 and
returns the economy to
its initial position

Temporary
fiscal
expansion shifts the DD
schedule and restores
full employment at point
3 but there is a greater
appreciation
of
the
currency
Problems of Policy Formulation

Inflation Bias: Macroeconomic policy can display an inflation bias,
leading to high inflation but no average gain in output. Government
can raise output when it is abnormally low (-creating a politically
useful economic boom). Workers and firms may anticipate this and
raise wage demands and prices. The government then has to use
expansionary policy to prevent a recession.

Disturbance Source: Government concerned about the effect on
exchange rate by its policy needs to know the source of the
disturbance before it can choose between monetary and fiscal policy.
This is in reality not easy.

Bureaucracy: Shifts in fiscal policy are often made after lengthy
legislative deliberation, while monetary policy is usually exercised
quicker by the central bank. Governments are likely to respond to
disturbances by changing monetary policy even when fiscal policy
would be more appropriate.
Problems of Policy Formulation

Government Budget Impact: A tax cut or spending increase may lead
to a larger government budget deficit, which must sooner or later be
closed by a fiscal reversal

Time Lags: Policies appear to act swiftly in our model because it is
simple. In real life, they operate with lags of varying lengths.

Precision of Forecasts: Evaluating the size and persistence of a given
shock makes it hard to know exactly how much monetary or fiscal
policy to administer. This forces policy makers to base their actions on
forecasts and hunches that may turn out to be quite wide of the mark.
Permanent Monetary Expansion
In the long-run, we assume the economy is at a
long-run equilibrium position and the policy
changes are the only economic changes that
occur (other things equal)
Rh = Rf
Temporary increase in Ms causes the asset market
equilibrium schedule to shift upward
Permanent increase in Ms, however, affects the
expected future exchange rate, E, leading to a
proportional rise in Ee, causing a higher shift in
AA (than temporary increase)
Output is above its full-employment level and
labor and capital are working overtime
Permanent Monetary Expansion
Price level P is rising to keep up with rising
production costs (workers demand higher wages
and producers raise prices to cover their
increasing production costs).
Domestic goods are more expensive relative to
foreign goods, discouraging exports and
encouraging imports causing DD to shift left
Increasing price level reduces money supply
causing AA to shift left
The economy therefore adjusts at 3 to a
permanent increase in money supply
Permanent Fiscal Expansion
Has impact in the output market and affects the
asset markets through its impact on long-run
exchange rate expectation
Rise in G causes DD to shift right causing long
run appreciation of currency pushing AA
downwards and output remains unchanged all
due to additional expectation of appreciation
Appreciation “crowds out” aggregate demand
for domestic products by making them more
expensive relative to foreign
Macroeconomic Policies
and the Current Account

XX, shows combinations of the exchange rate and
output at which the current account balance would
equal some desired level, CA(EP*/P, Y - T) = X. Along
XX, the current account is constant at the level CA = X

Arise in Y encourages spending on imports, worsening
the current account unless a currency depreciates

Since actual level of CA can differ from X, the
economy’s short-run equilibrium doesn’t have to be
on the XX curve

XX is flatter than DD (along DD, the domestic demand
for domestic output rises by less than the rise in
output itself (since income is either saved or spent on
imports))

To prevent an excess supply of home output E must
rise quickly along DD to make export demand rise
faster than import demand ie CA must rise sufficiently
along DD as output rises to compensate for domestic
saving

To the right of point 1, DD is above XX curve, CA > X;
to the left of point 1, DD lies below XX curve (CA < X)
Monetary expansion moves the economy to point 2 and thus
raises the current account balance.
Temporary fiscal expansion moves the economy (DD) to point 3,
while permanent fiscal expansion moves economy (AA) to point
4; in either case, the current account balance falls
Gradual Trade Flow Adjustments
& Current Account: J Curve

Underlying the DD-AA model, we assume a
real depreciation of the home currency
improves the current account while an
appreciation worsens it

Reality = more complex

J Curve: It is observed that a country’s
current account worsens immediately after a
real currency depreciation and begins to
improve after some months later (most
import and export orders are placed months
in advance reflecting buying decisions that
were made on the old real exchange rate).

Point 3 is reached within a year of the real
depreciation in most industrial countries,
and the current account continues to
improve afterward
Gradual Trade Flow Adjustments & Current
Account: Exchange Rate Pass through and
Inflation

To understand how nominal exchange rate movements affect the
current account in the short run, we examine closely the linkage
between nominal exchange rate and prices of exports and imports

The percentage by which import prices rise when the home currency
depreciates by 1% is known as the degree of pass-through from the
exchange rate to import prices

If you buy a car from South African manufacturer at the price of
R1.5m (at the exchange rate of K0.96/R) that costs K1,440,000 but if
the kwacha depreciates to K1.01/R in a year then the car will cost
K1,515,000, a difference of K75,000 to the Zambian importer. If the
Zambian importer pays the whole K75,000 then that’s a 100% or
complete pass through (or the degree of pass through is 1)
Exchange Rate Pass through and
Inflation

In the version of the DD-AA model above, the degree of pass-through
is 1; any exchange rate change is passed through completely to import
prices.

With P also fixed in the short run in our model, this implies a passthrough of 1 to the foreign prices of exports.

However, exchange rate pass-through can be incomplete

In our previous example, importer might decide to absorb 40% of the
price increase (K30,000) and the importer pays 60% (K45,000) meaning
importer pays K1,485,000. (The degree of pass through is 0.6)

Incomplete pass-through has complicated effects, on the timing of
current account adjustment because of slow adjustment of trade
volumes to slow adjustment of relative prices
Gradual Trade Flow Adjustments & Current
Account: Current account, wealth and
exchange rate dynamics

A permanent fiscal expansion would cause both an appreciation of the
currency and a current account deficit, transferring wealth to
foreigners.

Domestic consumption is falling over time and foreign consumption is
rising.

Foreigners have a relative preference for consuming the goods that
they produce, and as a result, the relative world demand for home
goods will fall and the home currency will tend to depreciate in real
terms.

Initially, the home currency will appreciate as the current account
balance falls sharply. But then, over time, the currency will
depreciate
The Liquidity Trap

Once an economy’s nominal interest rate falls to zero, it becomes
difficult for the central bank to reduce it further by increasing money
supply. Policy makers are trapped. They may be unable to steer the
economy through conventional monetary expansion.

Why? At 0% interest, people find money preferable to bonds, therefore
bonds would be in excess supply.

To clearly see the dilemma a central bank faces when the economy is
in a liquidity trap, we consider the interest parity condition when
domestic interest rate Rh = 0,
Rh = 0 = Rf + (Ee - E)/E

If the expected future exchange rate, Ee , is fixed, the central bank
raises the domestic money supply so as to depreciate the currency
temporarily (raise E today but return it to Ee later)
The Liquidity Trap

IRP shows that E can’t rise once R = 0. Interest rate would have to
become negative. Despite increase in the money supply, exchange
rate remains steady at E = Ee /(1 - Rf).

Currency cannot depreciate any more

At R = 0, people are indifferent about trades between bonds and
money.

People will accept the additional money in exchange for their bonds
with no change in the interest rate from zero and, therefore, no
change in the exchange rate

An increase in the money supply will have no effect on the economy

A central bank that sells bonds will eventually push interest rate up
(but this doesn’t help when the economy is in a slump and a fall in
interest rates is what is needed)
The Liquidity Trap
At point 1, output is trapped
below full employment level.
Exchange rate expectations Ee
are fixed
The flat segment of AA shows the
currency
cannot
depreciate
beyond the level Ee /(1 - Rf)
Monetary expansion prolongs
horizontal stretch of AA